When is it Time to Move on From a Sole Proprietorship?

At Maselli Warren, P.C. our attorneys have helped guide businesses of all sizes through their legal issues. Whether your business is a one person start-up or a several hundred person operation, you need to protect your company name and assets. In earlier blog posts, we had previously discussed other types of organizational structures for businesses — namely corporations, partnerships and LLCs. While each of these articles delved into some of the advantages, disadvantages and other complexities of these structures, one type of business structure was left completely unaddressed: the sole proprietorship.

Business contract

A Sole Proprietorship May be Appropriate in Very Limited Circumstances

When simplicity or up-front costs are the foremost considerations, a sole proprietorship may be suitable in certain circumstances. However, in most circumstances, a sole proprietorship is a rarely an advisable business structure once your company is engaging in significant business transactions. In some jurisdictions, simply being engaged in business for yourself makes you a sole proprietor. Photographers, handymen, contractors, artists, and freelancers of all types are very often actually sole proprietors. In New Jersey and Pennsylvania to form a sole proprietorship you must:

  • Come up with a name for your company. This name should be uniquely identifiable on a state and national level.
  • Record your trade name by filing with the appropriate county clerk in New Jersey. In Pennsylvania, file with the Pennsylvania Department of State.
  • Obtain the proper permits as required by your local town or city
  • Apply for an obtain an Employer Identification Number from the IRS if you plan to have employees

Thus a sole proprietorship can get your business off the ground, so to speak, quickly and cheaply. Further, in the first few years when many businesses suffer losses, a sole proprietorship can have tax benefits. Because it allows the business owner to include business losses as personal liabilities, significant personal tax savings may be available.

However, as your business grows and maybe even at the outset, the limitations of a sole proprietorship are likely to become more apparent. Perhaps the most significant of these disadvantages is unlimited personal liability for business debts.

Business people shaking hands, finishing up a meeting

But a Sole Proprietorship May Expose Your Personal Finances to Disaster

As we have discussed, a sole proprietorship allows business profits and losses to “pass through” to the personal assets of the sole proprietor. While potentially useful for tax purposes, the principle when applied to liability can have disastrous consequences. Unlike corporations and LLCs which shield the personal assets of a business owner, a sole proprietorship does not. That is, the owner is not only liable for business debts through his company, but also through his personal finances. Let’s look at two examples to see the full impact of this element of this structure.

Let’s assume that John has a successful Philadelphia business selling cheese steaks from a food truck outside of Phillies games. For many years John’s Cheese Steaks has been run as a sole proprietorship because John could not be bothered with, “paying to fix something that wasn’t broken”.  For years he would sell out of his cheese stakes each night after a Phillies’ game. Then, one hot summer day, he decides that his limited inventory is causing him to leave money on the table. He signs a contract that doubles his steak order for the remaining 2 months of the season. Unfortunately just one week later, the Great Beef Scare of 2020 is reported in the news and, almost overnight, demand for beef plummets. John cannot even give away a cheese steak now. Everyday more and more of his inventory spoils and must be discarded. Eventually the matter is referred out to a law office that sues both John’s business and John personally. Because of the form of John’s business as a sole proprietorship, he faces not only the potential dissolution of his company but also the potential loss of his home or other personal assets to satisfy his business debt. Clearly this is an unacceptable risk and would be a deterrent to entrepreneurship if corporate structures that protected personal assets were not available.

Let us go back to John’s cheesesteak business to take a look at liability in a different light. Except this time rather than a food-borne illness greatly reducing the demand for the product, here John has decided that he is too old to go down to Citizen’s Bank Park everyday. to keep his business operating he hires an employee. Unfortunately John’s employee is a bit disorganized and loses track of the time. This night, the employee was running late and rushing to get to the parking lot to set up. On the way, the employee loses control of the food truck and barrels into a row of parked cars injuring near-by tailgaters. Those who have suffered damages due to John’s employee are likely to be able to seek compensation not only from John’s Cheesesteaks, but also from John’s personal assets.  Once again, John may face the destruction of his business, but if he had worked with an experienced business planning attorney the economic damage probably would have been limited.

Stressed Man Worries About Economy, Paying Bills, Retirement

A Sole Proprietorship — Appealing but Dangerous?

Many businesses begin as a sole proprietorship and there is nothing wrong with that. Businesses with few liabilities or businesses that are still in their formative stages may be uniquely suited for a proprietorship. After all, sole proprietorships do provide the most control, the simplest structure and the lowest costs of administration. But as your company’s liabilities increase, a sole proprietorship is unlikely to remain a wise corporate structure. Simply put, unlimited personal liability for business debts and obligations is an unacceptable risk for most entrepreneurs. Further, because of the simplicity of the structure meaning that stock cannot be sold, it can be difficult to raise additional funding.

While a sole proprietorship is often a useful vehicle to launch a business, it generally should not be relied on beyond the extremely early stages of your company’s development. Working with an experienced business planning attorney can help you by structuring your business to protect your assets and encouraging the infusion of outside capital. To consult with a meticulous Maselli Warren, P.C. attorney today, please call (800) 891-2657 or contact us online.